Early redemption penalty: Costs and alternatives | key4.ch

Early redemption penalty: How much does it cost to terminate a mortgage early?

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30.05.2021 | 6 minutes

Previously, the five-year fixed-rate mortgage was the most popular mortgage product in Switzerland. Today, the trend is moving towards mortgage terms of ten years or more. Many homebuyers are primarily concerned with playing it safe with their budget. Their main priority is a fixed interest rate, but what would happen if you needed to terminate the mortgage agreement unexpectedly?

Terminating a mortgage early

Sometimes life gets in the way of our best-laid plans. When faced with divorce or a move away for work-related reasons, the following question arises: “Can I terminate my mortgage early?”. The same is true for unexpected events and strokes of misfortune such as prolonged unemployment, serious illness, disability or the death of a partner.

“Early redemption penalty” (Vorfälligkeitsentschädigung) is the key term around which everything subsequently revolves. In mortgage agreements and general terms and conditions, certain rules of play apply in these scenarios because terminating or paying off a mortgage early ultimately poses some tricky questions. Are there provisions for this in the mortgage agreement? And if so, how quickly and under which conditions would a customer be released from the loan agreement?

Early redemption penalty – the basic facts

Since the bank originally refinanced the mortgage on a long-term basis, it is entitled, in accordance with established case law, to demand compensation in the event of the mortgage loan being terminated early. The exit costs are always based on the interest rate differential:

  • For example, the bank contractually guaranteed and refinanced a fixed-rate mortgage of CHF 500,000 at an interest rate of 1.2%. The capital procurement (Kapitalbeschaffung) and the interest rate guarantee (Zinsgarantie) involve a great deal of expense and administrative effort on the part of the bank.
  • If, contrary to the agreement, a mortgage is paid off early, the investment interest revenue is lower. In this current environment of extremely low interest rates, even a reinvestment interest rate (Wiederanlagezins) of 0% or less would be conceivable (i.e. an environment with negative interest rates).
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Terminating a mortgage – three factors

The early redemption penalty essentially depends on three factors:

  • The mortgage amount already repaid
  • The interest rate difference between the contractual mortgage interest rate and the interest rate revenue on the money and capital market (reinvestment interest rate)
  • The remaining contractual term

In individual cases, it is not easy to calculate the early redemption penalty to which the bank is entitled. Specifically, it depends on the wording of the respective mortgage agreement and the general terms and conditions. Often, in practice, only experts can assess what the realistic reinvestment rate might be on any given date.

The situation becomes even more complex if a borrower wishes to pay off or terminate several tranches with different terms early.

The standard industry practice of compensation applies regardless of what prompted the customer to terminate the mortgage early. Sometimes, the desire to pay off a mortgage early arises because interest rates have fallen since the agreement was signed. In these cases, property owners should only pay off the existing mortgage if the interest savings will exceed the early redemption penalty. UBS key4 mortgages can advise homeowners who are thinking about paying off their mortgage early and provide support every step of the way. Learn more about switching options here.

Compensation for SARON mortgages

The principle whereby banks must receive compensation for refinancing and lost interest also applies to SARON mortgages. However, these products are much more flexible in this regard. Consequently, the customer has the right to switch from a SARON mortgage to a fixed-rate mortgage from the same provider at all times, and to do so free of charge.

Incidentally, the SARON mortgage from UBS key4 mortgages is subject to a 13-month notice period. If a customer wants to pay off or terminate the mortgage within an even shorter period of time, they must pay compensation in accordance with the aforementioned rules, the only difference being that, for this comparatively short remaining term, the outstanding amount is usually not too high. If flexibility is important to you, you should incorporate SARON mortgages into your strategy.

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Early redemption penalty – examining alternatives

In recent years, fixed-rate mortgages with long fixed interest rates have proven to be extremely popular. The vast majority of customers wants to secure their budget with low-cost fixed-rate mortgages for as long as possible. However, in the case of very long-term agreements, the early redemption penalty could be correspondingly high. Nonetheless, the following constructive solutions are available in real life:

Solution 1: Transfer the mortgage to another owner

If a homeowner is forced to sell after a divorce, for example, it may be worth talking to the future owner. Instead of terminating the mortgage early, it may be possible to transfer the mortgage to the buyer. Of course, both the future owner and the bank must agree to this. If the mortgage in question has a higher interest rate than current mortgage offers, it would be fair to negotiate compensation in this case.

Solution 2: Transfer the mortgage to another property

A second alternative is to transfer the mortgage to another property. Let’s assume a property owner is moving from Basel to St. Gallen for work reasons and acquires another residential property in their new place of residence. The mortgage “moves” too. This scenario is not so simple from an administrative and legal perspective, for example, issuing promissory notes (Schuldbriefe). In principle, however, it is a good idea to negotiate with the bank on transferring the mortgage to your new home.

Solution 3: Adjust the early redemption penalty

Can the early redemption penalty be negotiated? Perhaps, but all lawyers unanimously agree on the binding force of an agreement (pacta sunt servanda). In practice, the bank will take individual circumstances into consideration. For example, it makes a difference whether follow-up financing after this extraordinary termination (ausserordentliche Kündigung) will be with the same bank or not. The bank must also take cases of exceptional hardship into consideration.

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Early redemption penalty partly tax-deductible

Finally, the question arises as to whether an early redemption penalty is deductible from taxable income in the same way as interest on debt. Reminder: Under Swiss tax law, every homeowner is entitled to deduct private debt interest (including mortgage interest) from their taxable income, up to the amount of property income plus CHF 50,000.

In legal terms, however, it would be too simple to just add an early redemption penalty to the debt interest. According to a landmark federal court ruling, the early redemption penalty is only deductible if the customer takes out a new mortgage with the same bank. In other words, there must be a connection with the original mortgage.

It is a different scenario if a customer terminates a mortgage because they wish to sell the house unencumbered (i.e. without a continuing mortgage). According to case law, the early redemption penalty is not deductible from income in this case. However, these costs are considered as an expense by the owner and are therefore included in the investment costs, which, in turn, may be deducted when calculating any taxable gain on the property.

Conclusion: Consider the early redemption penalty from the outset

To sum up, when signing a mortgage agreement, homebuyers should give some thought to various aspects of the agreement and find the most suitable solution for them. In addition to the interest costs alone, this also includes the general terms and conditions of the agreement and, in particular, any provisions in relation to extraordinary termination. In other words, if you deal with the issue of an early redemption penalty in advance of taking out a mortgage, you won’t be unpleasantly surprised later if the worst comes to the worst.

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